The Independent Market Observer

Being a Good Investor: How to Worry in a Productive Way

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 30, 2015 1:58:00 PM

and tagged Economics Lessons

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being a good investorI gave a talk last night to a group of clients, part of which included a discussion of the possible reasons behind recent market turbulence. Afterwards, a client asked me what else, beyond what I had discussed, could have caused the downturn? I thought that was an interesting way to look at how we as investors should watch markets.

Being a good investor

Part of being a good investor is being aware of what could happen. The more deeply you think through possibilities, the less likely you are to get blindsided if and when something does go wrong. In answering this client’s question, I came up with at least two dozen additional reasons why the market could have declined, even taking China out of the mix. As the client said afterwards, it is kind of a miracle the market ever goes up, with all of the things that can go wrong.

And yet, of course, it does, which brings us to the second part of being a good investor, which is understanding when the possibilities identified above are likely to become actualities; for example, when that minor downturn is likely to turn into a crash—as in 2000 and 2008—or when (in a different context) that border skirmish is likely to become a war. You have to have a filter that separates possibilities from real dangers—and also from real opportunities.

Filtering out the noise

This is the basis of my own research interests. I frequently turn to the following two methods, for example, to zero in on potential problems:

  1. My monthly Economic Risk Factor Updates highlight what I consider to be the best filters for identifying a real pending recession from normal noise in the data.
  2. I use the 200-day moving average as a good initial filter for identifying a market that may be going into a significant decline.

Although these are both good ways to identify problems, they also have weaknesses. The 200-day moving average, for example, is wrong about two-thirds of the time. The ensemble of recession indicators is right much more often, but it doesn’t actually give us a time frame. In both cases, you need to continue to apply judgment along the way.

This approach also illustrates where other indicators can be wrong. I have written before about how I disagreed with those predicting the collapse of the dollar. I didn’t disagree because it was not possible—it was and it is—but because the transition from possibility to actuality would necessarily require certain events to occur, none of which actually did. Until certain events happen, that collapse simply is not in the cards, and none of the precipitative events look at all likely for the foreseeable future.

It’s like a premortem, where you try to figure out in advance how something terrible happens; you develop the exact sequence of possible events—and then you check to see if they are actually happening.

What does this mean for us today?

What this means today is that if we want to consider the possibility of a further significant decline in the market, then we also need to consider what would need to happen in order for that to occur. This is an interesting analysis, and we will take a look at it over the next couple of days.

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